A Holiday Rally Foments Fears of Froth

CONSUMERS MAY BE SPENDING MORE on travel and services than on items at retailers, which would explain the strong credit-card data and weak retailer reports. Consumers also could be purchasing more gift cards than they have in the past. Gift card spending isn't reflected in retailers' sales until the card is actually used. The use of gift cards has grown to about 8% of consumer spending, and if card sales have picked up this year, retailers' results may improve soon. Analysts note that when consumers use gift cards they tend to buy higher-margin products and spend more than the amount given on the card.

"I think things are in better shape than the retail-sales numbers have indicated this season," says Sloterbeck. As a result, ISI's Chief Investment Strategist Jason Trennert suggests buying retailers now, in expectation of a first-quarter rally, which is the typical seasonal pattern retail stocks enjoy.

The Peak of Power

Last week's big merger news came from Exelon, a Chicago-based utility that agreed to acquire New Jersey-based
Public Service Enterprise Group
for $12 billion in stock and the assumption of $14.1 billion in debt. The news sent Exelon shares up 5% on the week to 44.15 and PSEG shares up 9% to 51.66. PSEG stock could gain a bit more if the deal closes because each of its shares will be swapped for 1.225 Exelon shares, giving PSEG shares an implied value of $54.

Despite many regulatory hurdles, investors appeared to approve of the deal, in part because of the $1 billion of savings expected in the first two years the two utilities are combined. That helps make the deal accretive to earnings. In addition, Exelon is perceived as a well-run utility that can improve PSEG's operations.

Before the deal's announcement, Exelon's shares were up 32% this year. PSEG's shares had gained only 8%, a respectable amount given the broader market's performance but well below the gains of other utilities.

The Dow Jones Utilities Average is up a stunning 26% this year, having benefited from the continuation of low interest rates in the bond market and investors' insatiable demand for high-yielding stocks. "People were worried about rising interest rates going into 2004 and it just didn't happen," says Craig Shere, a utility analyst with Calyon Securities, a unit of Credit Agricole Group.

The 10-year Treasury bond yield started the year at 4.26% and now stands at 4.22%, making the dividends of many utilities quite competitive. That's especially true since President Bush lowered the tax rate on individuals' dividend income. The highest yielders in the Dow Utility Index include
Consolidated Edison,
with a 5.1% dividend yield, and
Duke Energy
and PSEG, with 4.3% yields.

The index also benefited from a number of successful restructuring stories, like
TXU,
which gained 172% and Williams Companies, which soared 68%. Both have been selling off unwanted assets and paying down debt. Williams, like some other companies, has benefited from the rise in energy prices since it boasts natural gas reserves in the Rocky Mountains.

Exelon has also benefited, albeit indirectly, from higher gas prices. Gas-powered utilities have had to charge more for electricity to cover the increasing cost of natural gas this year. Electricity prices are up more than 10% this year, says Gordon Howald, a utility analyst with Natexis Bleichroeder. Exelon has enjoyed that increase in revenue, but it has many nuclear-powered plants and the cost of running them hasn't risen, so Exelon's margins have improved.

After this year's healthy run, however, utilities can no longer be deemed as undervalued and they once again face the risk of rising interest rates. The price-earnings multiple on the S&P utility index is 92% of the S&P 500's multiple and that's extremely high compared to the norm, says Scott Soler an analyst with Morgan Stanley. Over the past 20 years, the utility index's multiple has averaged 77% of the broader market's and the group tends to peak right around current levels, Solar says. It's "hard to think these stocks have a lot of upside," he says.

The potential exception: If interest rates remain near historic lows or if President Bush further reduces or eliminates the tax on dividend income.

Head Over Shoulders

The market averages have broken through significant levels in the past few weeks, giving technical analysts reason to pour over their charts to try and divine the markets' next move.

Louise Yamada, head of technical research at Smith Barney, is excited about the future because she spies an inverse "head-and-shoulder pattern" in the S&P and Nasdaq. Literally, if you looks at a chart of the S&P going back to Aug. 24, 2001, the index creates the image of an up-side-down head and two shoulders. A horizontal line connecting the two shoulders is the neckline.

The difference between the neckline and the market's low during that period is the amount by which the market can subsequently rise. In this case, the difference is 381 points. So, Yamada believes that over a period of time, the S&P could find its way to 1,538.76.

"A head-and-shoulders pattern doesn't occur often, and it often indicates a major reversal, whether it be at the top or the bottom of a market," she says.

The Dow doesn't currently show the same pattern, but it has consolidated 2003's gains over the past year and, after last week's breakout, it looks ready to continue to rally. Nasdaq also shows an inverse-head-and-shoulders pattern, which could indicate the index will continue to rally to 3,000 or so. Yamada is quick to point out that these patterns don't signal how long it will take to reach such rosy targets, but they are optimistic signs nonetheless.

That said, two people looking at the same picture can have very different interpretations. While Dick McCabe, chief market analyst at Merrill Lynch, expects the market's strength to continue into the early part of '05, he's much more cautious about the rest of the year. "As we move on through 2005, we're going to see things get sloppier," he says.

McCabe predicts the Dow will trade as high as between 11,200 to 11,300 by early next year, the S&P will hit 1250 to 1275 and the Nasdaq will reach 2250 to 2300. But after that, the two-and-a-half year old bull market will start to get tired and the bear may reappear.

McCabe notes that every four years the market has a correction, and that fourth year happens to be in 2006. It's also the second year of the president's term, which usually doesn't bode well for the market. And the market currently appears overbought, with market sentiment much more bullish than it was this fall.

Both market technicians do like the same sectors: energy, capital goods and industrials. While these groups have performed admirably over the past year, they're coming off many years of consolidation and underperformance, which may have set them up for a long bull cycle.

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